June 29, 2010

Is it OK to Walk Away from Your Home?

After the real estate bust and recession the foreclosure rate went up considerably.  A lot of people are losing their homes because of unemployment or other personal financial problems.   However many other people are purposefully walking away from their mortgages even though they could still afford the payments.   This second group is doing something called "strategic default".   These people walk away from their mortgage not because they can't afford it but simply because its in their own financial interest.

Is it "OK" to walk away?   Personally I think that really depends on the details.

Lets consider a couple different situations.

Smith Family

You buy a home in 2006 and stretch to make the payments. Your mortgage lender convinced you that you could afford it, convinced you not to put 20% down and instead do a 80/20 loan to avoid PMI.  The payments are 40% of your income at the time that you buy.  Your credit is only average and the loan was a 2 year interest only, no document ARM that started at 6.5% and has adjusted to 5.5%.   The mortgage lender was fined by the federal government for predatory business practices.  Several of the homes in your area were bought and flipped as part of a mortgage fraud scam which artificially fueled the increase in prices.   Your house should never have been valued as high as it was in the first place.  You are relatively young and have little in savings, you spent most of your savings 4 years ago to get into the home.   You've since had 2 kids and have developed a serious illness which means you can't work so you rely on 1 income of $40k and they cut back on overtime and the local unemployment rate is 12%.   Your mortgage payments are a difficult stretch for you to pay all your bills.  You have next to nothing in savings.  You're frugal and live well within your means.  etc.   Your current neighborhood has really gone down hill lately with many vacant homes and crime has increased.  You have job prospects in the next state with potential for a good pay raise.   You paid $355k for the house and it is currently worth only $290k.   Should the Smith family walk away?  

Jones Family

You and your spouse make a combined $180k.   You're in your 50's and your kids are grown up and moved out.   You purposefully bought the house with 0% down because you figured that the rising housing prices you'd make the maximum return on your investment if you leverage the low 6% mortgage 100%.   You have $370k in the bank, you own a vacation home outright and you have secure stable jobs with the federal government.   You plan to live in this house the rest of your lives.   You bought the home for $250k and it is now worth about $180k.   Should the Jones' walk away?

Two Very Different Situations

If you compare the Smith and Jones families then there are very considerable differences.    Its true that both families knowingly signed mortgages and bought homes they could afford at the time they bought them.  Both families are currently able to make their mortgage payments.   However the the circumstances that the Smiths and Jones bought their homes were very different.    The Smiths were misled by a crooked lender and fell pray to a fraudulently inflated local market.   The Jones intentionally leveraged their home in a speculative gamble.   The current financial situations of the two families is also very different.   The Jones could pay their mortgage off with cash and could carry their payments with no financial strain at all.   The Smiths are teetering on the brink of financial ruin and struggling to cover expenses.

Every situation is Unique

Obviously these are fairly contrived examples made to illustrate the point.   At one end you have the Smiths who are victims and in financial desperation and at the other end the Jones who gambled with a low down payment and are in great shape financially.  Defaulting on a debt is never a good thing, but sometimes it is the right decision.   If someone is in serious financial jeopardy than walking away from a home loan is appropriate.   On the other hand if someone is just looking to cut their losses or maximize their gains then balking on debt is not OK in my opinion.   And there is an infinite spectrum of individual situations with varying degrees everywhere in between.

Shouldn't the people at fault pay the most?    You could argue that every borrower ultimately signed on the line and accepted their debt so they are all responsible for their own actions.  You could also argue that the lenders as a whole were irresponsible and predatory and the banks ultimately bear the burden of responsibility for the real estate bust and borrowers are victims as a group.   I don't think either of these are completely right or wrong but that the answer lies somewhere in between.   Everyone involved in the mortgages is somewhat responsible and partially to blame for the situation. 

Whether its Right or Wrong, there are Consequences

If the Jones family decides to strategically default on their home to save them the $70k in negative equity then there are consequences to that choice.   First of all it will damage their credit which will cost them in other ways.   Depending on the laws of the state they live in they may be fully responsible for the short fall in equity and the lender may be able to come after them for that balance.  Normally the IRS would consider a cancelled debt to be taxable event but that is currently not being treated that way due to the Mortgage Forgiveness Debt Act and later extension.

Bottom Line:   Personally I don't think theres a single one size fits all answer here.  In some situations it is certainly not OK to walk away from a mortgage, but in some cases it is justified and makes sense.

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